Quantitative Easing (QE): Explanation and Definition | Billionaire Mentor

Quantitative easing is a sometimes-used monetary policy, adopted by the government to increase the money supply in the economy to further increase lending by commercial banks and spending by consumers. 

Quantitative Easing: Here's How It Works?
Quantitative Easing: Here's How It Works?

Quantitative easing is intended to maintain the price level or inflation. However, these policies can cause huge vicissitudes, leading to very high inflation levels. If commercial banks fail to lend additional reserves, this can lead to an imbalance in the money market.

What is Quantitative Easing (QE)?

Quantitative easing (QE) occurs when a central bank purchases long-term securities from its member banks. The central bank adds new money to the economy by purchasing these securities. Inflows result in falling interest rates, making it easier for people to borrow.

QE is a monetary policy tool, an extension of the Fed's open market operations, which is how the central bank affects the money supply. Another tool is to reduce interest rates. The Fed uses QE after reducing the fund's rate to zero. The Fed Fund rate is the basis of all other short-term rates. 

Key Takeaways:

  • Quantitative easing occurs when a central bank purchases long-term securities to boost the economy.
  • QE expands the money supply and encourages growth.
  • The Fed used QE to deal with the 2008 financial crisis.
  • It also revived QE in response to the COVID-19 epidemic.

How Quantitative Easing works?

The Federal Reserve gives cash to its member banks in exchange for assets such as bonds upon purchase of securities. Additional cash can then be lent.

The Fed also regulates the reserve requirement of banks, which compares to the amount of money they need to keep on hand, compared to what they lend. Reducing reserves allows banks to lend more money. Exiting more money increases the money supply, which leads to a drop in interest rates. Low rates are an incentive for people to borrow and spend, which stimulates the economy.

Important: A bank lends any deposit above its reserves. These loans are then deposited in other banks. They only hold 10% in reserve, lending the rest. That way the $ 1 trillion in Fed credit could become $ 10 trillion in economic growth.

To implement quantitative easing, central banks increase the money supply by purchasing government bonds and other securities. Increasing the money supply reduces interest rates. When interest rates are low, banks can lend with easy terms. Quantitative easing is usually implemented when interest rates are already close to zero because, at this point, central banks have fewer instruments to influence economic growth.

If quantitative easing itself loses effectiveness, the government's fiscal policy can also be used to further expand the money supply. As a method, quantitative easing can be a combination of both monetary and fiscal policy; For example, if a government purchases assets that include long-term government bonds that are being issued to finance per-cyclical deficit spending.

Special Considerations

If central banks increase the money supply, it can create inflation. The worst possible scenario for the central bank is that its quantitative easing strategy can lead to inflation without the expected economic growth. An economic situation where there is inflation, but no economic growth, is called stagflation.

Although most central banks are created by the governments of their countries and do some regulatory oversight, they cannot force banks in their country to increase their lending activities. Similarly, central banks cannot force borrowers to take loans and invest. If the increased money supply created by quantitative easing does not work through banks and in the economy, then quantitative easing may not be effective (except as a tool to facilitate deficit spending).

Another possible negative consequence of quantitative easing is that it can cause the devaluation of the domestic currency. While a depreciating currency can help domestic manufacturers because the exported goods are cheaper in the global market (and this can help stimulate growth), the falling currency value makes imports more expensive. This can increase the cost of production and the level of consumer price.

From 2008 to 2014, the U.S. The Federal Reserve undertook a quantitative easing program by increasing the money supply. This had the effect of increasing the asset side of the Federal Reserve's balance sheet, as it bought bonds, mortgages, and other assets. Federal Reserve liabilities, primarily the U.S. In banks, increases by the same amount and by 2017 exceeded $ 4 trillion. The goal of this program was to lend and invest those reserves to encourage overall economic growth for banks.

Example of Quantitative Easing

After the 1997 Asian Financial Crisis, Japan fell into an economic downturn. In early 2001, the Bank of Japan (BOJ) -Japan's central bank launched an aggressive quantitative easing program to curb deflation and stimulate the economy. The Bank of Japan went from purchasing Japanese government bonds to buying private loans and stocks. However, the Quantitative Easing campaign failed to meet its goals. Between 1995 and 2007, despite the efforts of the Bank of Japan, Japanese gross domestic product (GDP) fell from about $ 5.45 trillion to $ 4.52 trillion.

The Swiss National Bank (SNB) also used a quantitative easing strategy after the 2008 financial crisis. Ultimately, SNB had assets that exceeded the annual economic output of the entire country. This made SNB's version of quantitative easing the largest in the world (as a proportion of a country's GDP). Although economic growth in Switzerland has been positive, it is unclear how much of the subsequent recovery can be attributed to the SNB's quantitative easing program. For example, although interest rates were pushed below 0%, SNB was still unable to achieve its target. Inflation target.

In August 2016, the Bank of England (BOE) announced that it would launch an additional quantitative easing program to help offset any potential economic effects of Brexit. BoE had plans to buy £ 60 billion of government bonds and £ 10 billion in corporate debt. The aim of the scheme was to prevent interest rates from rising in the UK and to encourage business investment and employment.

From August 2016 to June 2018, the Office of National Statistics in the UK reported that gross fixed capital formation (a measure of business investment) was growing at an average quarterly rate of 0.4 percent. This was lower than the average rate from 2009 to 2018. As a result, economists are tasked with trying to determine whether the development would have deteriorated without this quantitatively easy program. 

On March 15, 2020, the US Federal Reserve announced its plan to implement up to $ 700 billion in asset purchases as an emergency measure to provide liquidity to the US financial system. This decision was made as a result of the rapid spread of the COVID-19 virus and the massive economic and market turmoil brought on by the ensuing economic shutdown. Subsequent actions have expanded this Qi action indefinitely.

Historical Examples of Quantitative Easing

The Bank of Japan has been one of the most enthusiastic champions of quantitative easing, implementing this policy for over a decade. The European Central Bank and the Bank of England also used QE in the wake of the global financial crisis that began in 2007.

The Fed began using QE to counter the Great Recession in 2008, and then-Fed President Ben Bernanke cited Japan's precedent as both similar and different from the Fed's plan. In three separate rounds, the central bank bought more than $ 4 trillion in assets between 2009 and 2014.

In the first round of QE during the financial crisis, Fed policymakers pre-announced both the amount of the purchase and the number of months it took to complete it, Tilly recalls. "The reason they did this was very new, and they didn't know how the market was going to react," he says.

By the third round of QE in 2013, the Fed moved away from announcing the number of assets to be purchased, instead pledging to "speed up or reduce" the purchase as the labor market or inflation approaches.

"During the financial crisis, this was a relatively unknown area and so the Fed was more cautious about messaging and more cautious about the number of purchases and the duration of their policies," says Merz. "Once the market did not address some of the concerns cited by critics, at that time the Fed was encouraged to consider expanding the program and doing it in larger sizes."

QE and Coronavirus Crisis

Based on some lessons learned from the Great Recession, the Fed resumed quantitative easing in response to the economic crisis caused by the coronavirus epidemic. Policymakers announced plans for QE in March 2020 — but without a dollar or time limit.

The unlimited nature of the latest example of QE is the biggest difference from the financial crisis. Because market participants felt comfortable with this policy until the third round of QE during the financial crisis, the Fed opted for flexibility to buy assets for as long as necessary, says Tilley. And in response to the announcement, the stock market "took off," Winter notes, with the S&P 500 rising nearly 68% from its lows by the end of 2020, at least due to QE's safety net.

Frequently Asked Questions

How does quantitative easing work?

Quantitative easing is a type of monetary policy in which a country's central bank tries to increase liquidity in its financial system, usually by buying government bonds for a long period of time from the largest banks in that country. Quantitative easing was first developed by the Bank of Japan (BOJ) but has since been adopted by the United States and many other countries. By purchasing these securities from banks, the central bank hopes to stimulate economic growth by empowering banks to lend or invest more freely.

Is Quantitative Easing Printing Money?

Critics have argued that quantitative easing is effectively a form of currency printing. These critics often point to instances in history where money printing has given rise to hyperinflation, such as in the case of Zimbabwe in the early 2000s, or in Germany in the 1920s. However, proponents of quantitative easing would point out that, because it uses banks as intermediaries rather than placing cash directly into the hands of individuals and businesses, quantitative easing carries less risk of causing fugitive inflation.

Does quantitative easing cause inflation?

There is disagreement as to whether quantitative easing causes inflation, and to what extent it can do so. For example, BoJ has repeatedly engaged in quantitative easing as a way of intentionally raising inflation within its economy. While these efforts have so far failed, inflation has remained at an extremely low level since the 1990s. 

Likewise, many critics warned that the use of quantitative easing by the United States in the years following the 2008 financial crisis would risk exposing risky inflation. But as of now, this increase in inflation has not materialized yet.

Quantitative Easing (QE) sends a powerful message to the markets

Central banks such as the Fed send a strong message to the markets when they choose QE. They are telling market participants that they are not afraid to continue buying property to keep interest rates low.

"This is a powerful indication that the Fed wants to stimulate economic growth and is an influential force on capital markets and asset prices," says Bill Merz, head of fixed income research at US Bank Wealth Management in Minneapolis. "That signaling effect has been by far the most influential component of quantitative easing."

QE is deployed during periods of great uncertainty or financial crisis that can turn into a market panic. The aim is to address immediate concerns in financial markets and even worse crises, says Luke Tilley, chief economist at Wilmington Trust in Philadelphia and former economic advisor at the Federal Reserve Bank of Philadelphia. 

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